If an economy is operating at its potential output level, a change in aggregate demand or short-run aggregate supply will induce an inflationary or a recessionary gap.

Question

Quizplus · Accepted Answer

If an economy is operating at its potential output level, any increase in aggregate demand will lead to a situation of excess demand in the short run, causing firms to increase their prices due to increased demand for goods and services. This will lead to inflationary pressure, resulting in an inflationary gap. On the other hand, any decrease in aggregate demand or increase in short-run aggregate supply will lead to a situation of excess supply in the short run, causing firms to reduce their prices due to weak demand for goods and services. This will lead to deflationary pressure, resulting in a recessionary gap.

If an Economy Is Operating at Its Potential Output Level